Who should read this Client Alert?
If you have derivatives contracts that are linked to, or refer to, floating rate indices you should read this client alert because your existing and future contracts may be affected and you will be receiving communications from your dealers to modify your contracts. This could affect commercial end users of derivatives, including corporates, funds, pensions funds and, of course, sell side financial institutions.
When will the process of amending derivatives contracts for LIBOR transition via a protocol begin?
Now. ISDA has launched the ISDA 2020 IBOR Fallbacks Protocol (the IBOR Fallbacks Protocol) and any entity can adhere to it, not just ISDA members. The amendments will then take effect on 25 January 2021.
What has happened?
ISDA has launched the much anticipated IBOR Fallbacks Protocol, which is designed to assist derivatives market participants with their IBOR transition plans. Adherence to the IBOR Fallbacks Protocol is seen by regulators across the world as a key part of firms’ LIBOR transition plans and was described by Andrew Bailey, Governor of the Bank of England, as an important step in the LIBOR “endgame” and by the Board of Governors of the Federal Reserve System (the Fed) as playing an important role in an orderly transition away from LIBOR. By adhering to the IBOR Fallbacks Protocol, derivatives counterparties would be incorporating the new robust fallback rates that would apply in the event of a permanent cessation of a key interbank offered rate (IBOR) and upon a non-representative determination for LIBOR (the London Interbank Offered Rate) into legacy deals with other adhering counterparties.
Given that the IBORs have a term structure and a credit element and the alternative risk-free reference rates (RFRs) are overnight rates with no credit component, adjustments are needed to the RFRs to ensure that derivative contracts that were originally negotiated to reference an IBOR continue to meet the original objectives of the counterparties to the extent possible once the fallbacks take effect. As a result of several ISDA market wide consultations, the RFRs will be compounded over the relevant IBOR period with a spread adjustment added to the compounded rate. The spread adjustment will be based on the median over a 5-year period of the historical differences between the IBOR in the relevant tenor and the relevant RFR compounded over each corresponding period.
With UK and U.S. regulators confirming that, notwithstanding the current COVID-19 pandemic, there is no change to the end of 2021 date set by Andrew Bailey in his speech in July 2017 after which time the UK Financial Conduct Authority (FCA) will no longer be persuading or compelling banks to submit quotes to LIBOR, there has been increased focus on transitioning existing deals to alternative RFRs before this time.
In the U.S., the Fed and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (the ARRC) to help ensure a successful transition to a “more robust” reference rate. In its recommended best practices, the ARRC recommended that “dealers and other firms with significant derivatives exposures” adhere to the ISDA IBOR Fallbacks Protocol promptly after it is published and before the amendments to legacy transactions take effect.
Do I need to adhere to the IBOR Fallbacks Protocol?
Although adherence to the IBOR Fallbacks Protocol is voluntary, regulators across the globe have urged regulated entities to sign up early.
The Financial Stability Board (the FSB) has released a statement welcoming ISDA’s announcement and encouraging adherence:
"The FSB encourages adherence to the Protocol as a tangible step that can be taken by both financial and non-financial firms to avoid disruptions in covered derivatives contracts if the IBOR they currently reference is discontinued or, in the case of LIBOR, becomes non-representative."
The Working Group on Sterling Risk-free Reference Rates has issued a joint statement, with the Bank of England and FCA also encouraging adherence: "the Working Group strongly encourages early adherence to the Protocol by both financial and non-financial firms.
The ARRC has also issued a similar announcement in support:
"In line with its Recommended Best Practices, the ARRC encourages market participants to adhere to the Protocol before it takes effect, and for those dealers and market participants with significant derivatives exposures to do so during the two-week escrow period ahead of the official launch date on October 23, 2020, in order to promote adoption on as timely a basis as possible".
In addition, under Article 28(2) of the EU Benchmarks Regulation, certain EU and UK regulated entities have a regulatory requirement to include robust written fallbacks in their contractual documentation. Edwin Schooling Latter of the FCA has said that signing the IBOR Fallbacks Protocol will meet this regulatory requirement and that the FCA will be asking hard questions as to why UK regulated firms have not signed the IBOR Fallbacks Protocol.
Firms that are not regulated by a financial regulator, such as commercial end-users, can expect their dealer counterparties to contact them regarding adherence to the IBOR Fallbacks Protocol and commercial end users should expect to be encouraged to adhere.
How does the IBOR Fallbacks Protocol work?
A protocol is a multilateral contractual amendment provision that is used to make standard amendments to ISDA documentation among adhering counterparties. By adhering to the IBOR Fallbacks Protocol, you would be agreeing that your legacy derivative contracts with other adherents to the IBOR Fallbacks Protocol will include the amended floating rate option for the relevant IBOR and will therefore include the new fallbacks that would take effect upon a permanent cessation of certain key IBORs or upon a non-representative determination for any LIBOR. The fallbacks will be adjusted versions (with the spread adjustment added) of the RFRs identified by public or private sector working groups in each jurisdiction as alternatives to the IBORs. The adjusted RFR in the relevant currency would apply as a fallback following a permanent cessation of the IBOR in that currency and, in respect of any LIBOR, following a determination by the FCA that LIBOR in that currency was no longer representative of its underlying market even it continues to be published.
Details of the IBOR Fallbacks Protocol together with a list of frequently asked questions can be found at the following links:
The IBOR Fallbacks Protocol will take effect on the Protocol Effective Date, which is 25 January 2021.
How could I amend my deals bilaterally?
ISDA has also published a suite of template documents in order to assist counterparties who may wish to incorporate the new fallbacks on a bilateral basis, which is available on the ISDA website here, together with an outline of bilateral forms for IBOR fallbacks.
What about new deals?
ISDA has also published a Supplement for the relevant IBORs to the 2006 ISDA Definitions, which incorporates the relevant amendments to the floating rate options that would apply upon the permanent discontinuation of certain key IBORs or upon a non-representative determination for any LIBOR. The Supplement will also take effect on 25 January 2021 and after that date transactions that are entered into that incorporate the 2006 ISDA Definitions will include the amended floating rate options. Any transactions entered into prior to 25 January 2021 will continue to be based on the existing 2006 ISDA Definitions without the amended floating rate option with the fallback.
The IBOR Fallbacks Supplement is also available on the ISDA website here.
What else to look out for?
ISDA is currently working on a revised version of the 2006 ISDA Definitions, the 2021 ISDA Interest Rate Definitions, which will incorporate the IBOR fallbacks.
You should consider whether your organization will be adhering to the IBOR Fallbacks Protocol, or, alternatively, whether you will be amending documentation on a bilateral basis to incorporate the new fallbacks into your legacy deals. In addition to reviewing carefully your derivatives documentation and the IBOR Fallbacks Protocol, you should reach out to your counterparties in order to ascertain whether they intend to adhere to the IBOR Fallbacks Protocol or whether they are amending documentation on a bilateral basis.
This note is for guidance only and should not be relied on as legal advice in relation to a particular transaction or situation. Please contact your normal contact at Hogan Lovells if you require assistance or advice in connection with any of the above.
Authored by James Doyle and Isobel Wright